Fed’s reserve hint may help ECB

Negative deposit rate possible for Europe

by David Marsh

Mon 25 Nov 2013

The US Federal Reserve has offered important indirect support that could help the European Central Bank (ECB) move towards negative interest rates on bank deposits at the euro bloc central bank in 2014.

Amid the welter of partially contradictory indications on monetary policy from the US and Europe, a path is gradually becoming more evident for transatlantic interest rates in coming months.

News that the Fed is considering cutting the interest it pays on bank reserves, as an offset to potential slowing of asset purchases through quantitative easing (QE), forms a significant part of the equation.

In effect the Fed is providing a substantial bridgehead to allow the ECB to cross into negative territory on deposits it offers. According to the minutes of the Federal Open Market Committee’s (FOMC) October meeting, released last week, most FOMC officials thought such a move ‘could be worth considering at some stage’.

This would offer a means of displaying continued easy monetary policy even after the so-called tapering of the Fed’s $85bn-a-month asset purchases.

In the delicate weeks before the probable replacement of Fed chief Ben Bernanke by chairman-designate Janet Yellen in January, this would be an elegant way of balancing hawkish and dovish QE tendencies among FOMC members. Some analysts think that the Fed could announce a slowdown in asset purchases as early as next month, depending on US employment data.

An important factor behind the ECB’s controversial 0.25 percentage point cut in its main interest rate to 0.25% on 7 November was uncertainty about US monetary policy. If the Fed started tapering in December, then it was surmised that this would have made the long-delayed ECB rate cut still less likely. This factor strengthened the resolve of the majority of the ECB council to pre-empt any Fed action, by reducing interest rates a month earlier than a substantial minority of the ECB council would have liked.

If, as now appears likely, the Fed decides to couple the start of tapering with a cut in interest paid on reserves, that could facilitate a further easing of ECB monetary policy. In view of widespread fears in Europe about the effects of austerity, and in particular about the threat of deflation in some countries, the ECB is conspicuously keeping options open.

Leading officials have been thinking aloud about the possibility of across-the-board QE in Europe, but the issue remains technically difficult and politically sensitive. Interest rate cuts – including a move into negative territory for the deposit rate as well as a landmark cut (not necessarily at the same time) to zero for the main ECB refinancing rate – still seem more likely than QE.

The lack of ECB enthusiasm for across-the-board QE was voiced 4 ½ years ago by then ECB board member Lorenzo Bini Smaghi. He set out six reasons why the ECB seemed unlikely to adopt large-scale purchases of government bonds as decided by the Federal Reserve and Bank of England. Since then, not much has changed.

The reasons included doubts whether an increase in the monetary base really would result in easier monetary conditions; whether banks would actually pass on the additional liquidity in the context of general deleveraging; whether inflationary expectations would rise; and whether central banks would suffer large losses by buying at high prices and selling at low ones.

Bini Smaghi hinted at the single most important reason for the ECB's reluctance: it could have a disproportionately large and positive impact on the bond markets of the most heavily indebted countries and be seen as granting privileged access for the most troubled governments.

With European policy initiatives becalmed by confusion over the composition and policies of the next German government, the ECB is again left alone as the most effective economic decision-maker in Europe.

On 16 September, a week before the inconclusive German general election on 22 September, I predicted difficult negotiations in Berlin on a Grand Coalition, bringing ‘weeks if not months of uncertainty and volatility in German politics – and no clear-cut end to the doubts overhanging economic and monetary union’. Two months on, this is a pretty fair summing up of the present situation.

Political sensitivities over a potential move to European QE have been exacerbated by continued doubts about whether the German Constitutional Court will give backing to the planned Bundesbank involvement in a key ECB policy instrument. This is the ECB’s not-yet-tested programme of OMT asset purchases for selected euro members. The Court has pointedly delayed until next year announcing its judgement on the matter. The Karlsruhe body is thought to be loath to announce a negative view on the issue that could unsettle markets at a time when Germany has no more than a caretaker government in charge.

Mario Draghi, the ECB president, last week criticised what he termed ‘nationalistic’ attacks on the latest ECB rate cut (above all from conservative German commentators). Draghi declared that members of the ECB council are acting as Europeans rather than representatives of individual countries.

This is indeed the official explanation of how the ECB acts. But many German analysts believe the latest ECB interest rate cut has been swayed more by the need to restore the health of banks and governments from the indebted European periphery, rather than by general desire for monetary and financial stability.